Access to Capital Among Young Firms, Minority-owned Firms ...

Access to Capital among Young Firms, Minority-owned Firms, Women-owned Firms, and

High-tech Firms

by Alicia Robb, Marin Consulting, LLC

San Rafael, CA for

Under contract no. SBAHQ-11-M-0203 Release Date: April 2013

The statements, findings, conclusions, and recommendations found in this study are those of the authors and do not necessarily reflect the views of the Office of Advocacy, the United States Small Business Administration, or the United States government.

ROBB: SBA-HQ-11-0033

Executive Summary This report examines access to capital by young and small businesses. The purpose of the

investigation is to gain a better understanding of access to capital by young firms and how the recent economic and financial crisis has affected their access to financial capital, especially among firms owned by women and minorities and firms that are high tech in nature. In light of the key role in small business finance played by financial institutions, this study pays disproportionate attention to access to bank loans. Although these issues are important, research has traditionally been limited by a lack of appropriate data. A primary obstacle has been the absence of representative samples of small businesses that contain detailed descriptions of their access to financing. The primary source of data on this question, the Federal Reserve Survey of Small Business Finances, was discontinued in 2003, and is thus unavailable for studying the effects of the financial crisis on small businesses.

A second obstacle has been the tendency of researchers to analyze data on cross sections of small businesses of varying ages and sizes at a single point in time. While the findings from these snapshots have been valuable to scholars and policymakers, they have also been limited. Because they are static, these snapshots do not capture the ways in which small business financing unfolds over the life cycle of the firm and changes over time. This study attempts to overcome these obstacles by examining the effects of the changing financial environment generally and the economic crisis specifically, on access to capital by small businesses over the 2004 through 2010 period, controlling for business and owner characteristics. Analyses of small-firm capital access are based upon firm subsets drawn from the Kauffman Firm Survey.

Key findings of this study include the fact that firms owned by African Americans and Latinos utilize a different mix of equity and debt capital, relative to firms owned by nonminorities. Relying disproportionately upon owner equity investments and employing relatively less debt from outside sources (primarily banks), the average firm in these minority business subgroups operates

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ROBB: SBA-HQ-11-0033 with substantially less capital overall ? both at startup and in subsequent years ? relative to their nonminority counterparts. Women-owned businesses exhibit some similar disparities in capital structure, relative to male-owned firms, in the sense of operating with much less capital, on average, and a somewhat different mix of debt and equity capital. Their reliance upon outside equity capital is particularly low. The initial disparities in the levels of startup capital by business owner race, ethnicity, and gender do not disappear in the subsequent years following startup.

The information asymmetry inherent with new and young firms is exacerbated in high technology industries due to the lack of tangible assets and their reliance on knowledge assets, as well as technical and market uncertainty. The information asymmetries associated with new firms in general, and high tech firms specifically, make traditional bank lenders less likely to lend to these firms. This report also examines financing patters of high tech firms.

This study will help government officials document significant racial and gender disparities in capital access, differences in lending patterns between high tech and non-high tech firms, and credit market conditions during the financial crisis. These results will help policymakers in developing policies to ensure optimal access to debt and equity capital among all small businesses, including during times of financial stress.

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ROBB: SBA-HQ-11-0033 Background

Access to capital for small businesses is one of the biggest policy issues in the United States today. This work has important implications for policy and policymakers at all levels. In particular, given the role of young firms and entrepreneurs in job creation and economic growth, policymakers need to ensure that entrepreneurs and creditworthy firms are able to secure adequate financial resources for growth and success. Ensuring that these firms have adequate access to financial capital enables them to continue to drive innovation, growth, and job creation in the U.S. economy.

The economics and finance literatures provide strong evidence that sufficient starting capital is a binding constraint for new firms. Entry into entrepreneurship increases with sudden increases in personal wealth, e.g. via bequest (Cagetti and De Nardi (2006)) or external change in taxation rate (Nanda (2008)), and with increased access to bank financing through deregulation and loosening of branching restrictions (Black and Strahan (2002)). Likewise, the absence of funds inhibits entry. For example, Evans and Jovanovic (1989) find that borrowing capacity limits entrepreneurial entry; using the National Longitudinal Survey they estimate that new entrepreneurs are limited by the size of their initial assets in starting a new business. So inequalities in personal wealth could translate into disparities in business creation and ownership.

We certainly see disparities in business ownership by race, ethnicity, and gender. The most recent statistics available from the Census Bureau come from the 2007 Survey of Business Owners (SBO). These data showed that women-owned firms made up 28.7 percent of the 27.1 million businesses in the United States, while minorities owned 21.3 percent of businesses. Clearly women and minorities are underrepresented in business ownership in this country, compared with white men. As the minority population continues to rise, it is more important than ever that these prospective business owners have the resources they need to launch successful firms. Financial capital is one such resource and previous research shows that much of the financial capital used to

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ROBB: SBA-HQ-11-0033 start businesses comes from the owners themselves.

Yet estimates from the U.S. Census Bureau indicate that half of all Hispanic families have less than $13,375 in wealth, and half of all African-American families less than $8,650 (Table1). Wealth levels among non-minorities are much higher. African-American wealth levels are just 8 percent of non-minority wealth levels, and Hispanic wealth levels are just 12 percent of nonminority wealth levels. Only Asians have wealth levels similar to those of non-Hispanic Whites. Low levels of wealth and liquidity constraints can create substantial barriers to entry for would-be entrepreneurs because the owner's wealth can be invested directly in the business, used as collateral to obtain business loans, or used to acquire other businesses. Investors frequently require a substantial level of an owner's investment of his/her own capital as an incentive.

Table 1

Median Household Net Worth by Ethnicity/Race, 2004

Total Non-minority Asian or Pac. Islander Hispanic African-American

Median

As a % of

Net Worth Non-minority

$

79,800

$

113,822 100%

$

107,690 94.6%

$

13,375 11.8%

$

8,650 7.6%

Source: U.S. Census Bureau, Housing and Household Economic Statistics Division (2011).

Previous studies find that relatively low levels of wealth among Hispanics and African Americans contribute to these groups having lower business creation rates relative to their representation in the U.S. population. Fairlie (2006) found that differences in asset levels are the largest single factor explaining racial disparities in business creation rates. He found that lower levels of assets among African Americans account for more than 15 percent of the difference between the rates of business creation among Whites and Blacks. Fairlie (2006) also found that

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ROBB: SBA-HQ-11-0033 differences in asset levels represented a major hindrance for business creation among Hispanics, while Fairlie and Woodruff (2009) studied the causes of low rates of business formation among Mexican-Americans in particular. An important factor that explains one-quarter of the business entry rate gap between Mexican-Americans and non-Hispanic Whites is asset levels.

Less research has focused on the related question of whether low levels of personal wealth and liquidity constraints also limit the ability of minority entrepreneurs to raise adequate levels of startup capital. Fairlie and Robb (2008) found that undercapitalized businesses had lower sales, profits, and employment, and were more likely to fail than businesses receiving optimal levels of startup capital. The common use of personal commitments to obtain business loans suggests that wealthier entrepreneurs may be able to negotiate better credit terms and obtain larger loans for their new businesses, possibly leading to more successful firms (Astebro and Berhardt (2003)). Cavalluzzo and Wolken (2005) also found that personal wealth, primarily through home ownership, decreases the probability of loan denials among existing business owners. If personal wealth is important for existing business owners in acquiring business loans then it may be even more important for entrepreneurs in acquiring startup loans.

Previous research indicates that the level of startup capital is a strong predictor of business success. (Bates (1997); Fairlie and Robb (2008)). Asian firms are found to have higher startup capital levels and resulting business outcomes (Fairlie and Robb (2008). As noted, their wealth levels are also on par with Whites. Therefore, I will focus on Blacks, Hispanics, and other nonAsians as one group, and compare them with Whites. I will also look at men and women separately.

Much of the recent research on the issue of discrimination in business lending uses data from various years of the Survey of Small Business Finances (SSBF). The main finding from this literature is that MBEs experience higher loan denial probabilities and pay higher interest rates than White-owned businesses even after controlling for differences in creditworthiness, and other

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ROBB: SBA-HQ-11-0033 factors.1 Cavalluzzo and Wolken (2005) found that while greater personal wealth is associated with a lower probability of denial, even after controlling for personal wealth, there remained a large difference in denial rates across demographic groups. African Americans, Hispanics, and Asians were all more likely to be denied credit, compared with Whites, even after controlling for a number of owner and firm characteristics, including credit history, credit score, and wealth. They also found that Hispanics and African Americans were more likely to pay higher interest rates on the loans they obtained. Using the 2003 SSBF, Blanchflower (2007) also found Asian-Americans, Hispanics and African Americans were more likely than Whites to be denied credit, even after controlling for creditworthiness and other factors.

Banks have historically provided new firms with crucial growth capital, and have played a substantial role in new firm formation and business expansion both in the United States and internationally (Ayyagari, Demirguc-Kunt and Maksimovic (2010); Beck, Demirg??-Kunt and Maksimovic (2008); Kerr and Nanda (2009 )); Robb and Robinson (2012)). Black and Strahan (2002) show that deregulation of interstate banking and loosening of branching restrictions fostered increased entrepreneurial activity.

In times of financial distress, however, bank lending may be curtailed, with decreased lending potentially reflecting a "flight to quality" (Caballero and Krishnamurthy, 2008). Such effects have been pronounced in the wake of events such as the failure of Lehman Brothers in 2008 (Ivashina and Scharfstein, 2010), and more generally, in response to recessions (Gertler and Gilchrist, 1994; Holmstrom and Tirole, 1997)). Moreover, the flight to quality is seen as having a

1 Lloyd Blanchard, John Yinger and Bo Zhao,"Do Credit Market Barriers Exist for Minority and Women Entrepreneurs?," Syracuse University Working Paper (2004). Blanchflower, Levine and Zimmerman. Cavalluzzo, Cavalluzzo, and Wolken. Cavalluzzo and Wolken. Susan Coleman,"The Borrowing Experience of Black and Hispanic-Owned Small Firms: Evidence from the 1998 Survey of Small Business Finances," The Academy of Entrepreneurship Journal 8, (2002): 1-20. Susan Coleman, "Borrowing Patterns for Small Firms: A Comparison by Race and Ethnicity." The Journal of Entrepreneurial Finance & Business Ventures 7, (2003): 87-108. United States Small Business Administration, Office of Advocacy, Availability of Financing to Small Firms using the Survey of Small Business Finances, K. Mitchell and D.K. Pearce, (2004).

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ROBB: SBA-HQ-11-0033 greater effect on firms more subject to agency problems and information opacity (Gertler and Gilchrist, 1994).

If banks do indeed avoid making riskier loans in times of financial crisis, then it stands to reason that firms that are inherently more risky--such as young firms and firms in industries characterized by greater technical or market uncertainty--might be most affected by such events. One important question that the literature has not addressed is how the lending response in a financial crisis affects the youngest firms in general, and in particular, whether there might be a disproportionate impact on the riskiest of these firms (e.g., those in high technology industries). I will investigate the financing constraints of high tech firms specifically, in addition to firms owned by women and minorities.

In previous work using the KFS data, Winston Smith (2011) provided evidence that banks increase lending to high technology firms as information asymmetry and inherent uncertainty surrounding the firm are lessened. While high tech firms account for a relatively small percent of the full population of firms, they are disproportionately likely to contribute to economic growth through employment, revenue, assets, and innovations. Hence, access to sufficient financial capital for these firms is paramount to our economic recovery.

Data and Univariate Statistics

In this study, I examine the financing patterns of young firms during their early years of existence. The data are from the Kauffman Firm Survey, a nationally representative cohort of businesses that began operations in 2004, which are followed over the 2004 to 2010 period. One item of note is that these data represent a cohort of firms that began in 2004; the data are not representative of all startups or all businesses in the United States. New businesses were defined as

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